Put Option and Call Option – Everything You Need To Know

What are Options?

Options are contracts that give you the right—but not the obligation—to buy or sell an underlying asset at a specified price before a certain expiration date. Options give you flexibility in your investment strategy, allowing you to speculate on market direction with little capital or hedge existing positions against negative price movements.

It’s important to understand the simple building blocks of options prior to delving into more complex strategies:

• Underlying Asset: The security that the option contract is based on (stocks, ETFs, indexes, etc.)
• Strike Price: The agreed price at which you may buy or sell the underlying asset
• Premium: The cost of money you pay to buy an option contract
• Expiration Date: The date when the option contract expires
• Contract Size: Typically 100 units of the underlying asset

Options gain value from the value of the underlying asset and are a type of derivative financial instrument. Options, unlike stocks that can theoretically exist forever, are short-term and will expire worthless if not exercised or sold prior to expiration.

What are Call Options?

A call option gives you the right (but not the obligation) to purchase an underlying asset for the strike price on or before the expiration date. Think of calls as being able to “call away” an asset from another at a previously stated price.

Buying Call Options (Long Call)

When you buy a call option, you’re making a bullish bet that the price of the underlying asset will increase above the strike price plus the premium you paid. This strategy has several advantages:

• Limited Risk: Your worst loss is capped at the premium paid
• Unlimited Profit Potential: Gains increase as the underlying asset increases in value
• Leverage: Hold a large position with relatively little capital

For example, suppose XYZ stock currently trades at $50. You purchase a call option with a $55 strike price to expire in three months for a premium of $2 per share ($200 total per contract). When XYZ jumps to $65 before expiring, your option will be worth at least $10 per share ($1,000), giving you a 400% return on your initial $200 investment.

But if XYZ is still worth less than $55 at expiration, your option will expire worthless, and you will be out the entire $200 premium. The breakeven on this trade would be $57 (strike price + premium).

Selling Call Options (Writing Calls)

When you sell (or write) a call option, you are on the opposite side of the trade, getting the premium upfront but potentially obligating yourself to sell the underlying asset at the strike price. This can be accomplished in two ways:

• Covered Call: Selling a call against shares you own
• Naked Call: Selling a call without owning the underlying asset (higher risk)

Covered calls make you earn money on shares you hold, but limit your maximum possible return in the event of the stock appreciating significantly. The covered call strategy is attractive for income investors who seek to boost returns on stocks they are ready to sell at the strike price.

Naked calls are one of the riskiest option strategies because your hypothetical loss is unlimited if the underlying asset price increases substantially. This strategy should only be considered by experienced traders with a high risk level and amount of capital.

What are Put Options?

A put option gives you the right (but not the obligation) to sell an underlying asset at the strike price before the expiration date. It is like having the option to “put” your shares on another person at an assured price. 

Buying Put Options (Long Put)

When you purchase a put option, you’re making a bearish wager that the value of the underlying asset will fall below the strike price minus the premium paid. Purchasers of puts benefit from:

• Limited Risk: Maximum loss limited to the premium paid
• Large Profit Potential: Profit increases as the underlying asset decreases in value
• Portfolio Protection: Can act as insurance for existing long positions

For instance, if ABC stock is at $80, you may buy a put with a strike price of $75 in two months for a premium of $3 ($300 per contract). If ABC declines to $65, your put option is worth a minimum of $10 per share ($1,000), which is a 233% return.

If ABC remains above $75 at expiration, your option is worthless, and you lose the $300 premium. Your breakeven point is $72 (strike price – premium).

Selling Put Options (Writing Puts)

If you sell a put, you get the premium upfront but may need to purchase the underlying stock at the strike price if the holder exercises. Selling puts is good when

• You wish to earn money in a neutral or bullish market
• You are willing to buy the underlying asset at the strike price (potentially cheaper than the current market price)
• You are familiar with the risks and have sufficient capital to cover potential liabilities

Cash-secured puts involve the need to keep enough cash in hand to purchase shares if they are exercised, while naked puts do not include full collateral and are more risky, requiring higher trading experience and margin approval.

Pricing and Valuation of Options

Understanding how options are priced makes you capable of seeing value and not paying more than necessary for contracts. There are two components to options pricing:

1. Intrinsic Value: The amount an option is in-the-money (if any)

For calls: Max(0, Underlying Price – Strike Price)

For puts: Max(0, Strike Price – Underlying Price)

2. Time Value: The excess premium above intrinsic value

•    Reflects the probability of a favorable price movement before expiration
•    Decreases as expiration gets closer (time decay)

Several factors drive options pricing:

• Underlying Price: The current market price of the asset
• Strike Price: Pre-agreed exercise price
• Time to Expiration: Larger time horizons typically demand higher premiums
• Volatility: Higher expected price volatility means higher premiums
• Interest Rates: Higher interest rates will tend to raise call premiums and reduce put premiums
• Dividends: Expected dividend payments can impact prices

The Greeks of Options Pricing

“Greeks” are employed by options traders to measure different aspects of risk and price sensitivity:

• Delta: Represents how much the price of an option will move in response to a $1 move in the underlying instrument (between -1 and +1)
• Gamma: Represents how the delta will change (second derivative)
• Theta: Represents time decay or erosion of premium per day
• Vega: Represents sensitivity to changes in implied volatility
• Rho: Represents sensitivity to changes in interest rates

These strategies allow traders to understand how their options positions will behave in different market conditions and change their strategy accordingly.

Strategies for Options Trading

Options offer more than just buying and selling flexibility, enabling sophisticated strategies to accommodate nearly any market opinion or risk tolerance.

Covered Calls

This popular strategy involves owning the underlying and selling call options against your position. Benefits are:

• More income from collecting premiums
• Relatively lower risk than simply owning the stock
• Can be applied repeatedly to generate a steady income

The primary trade-off is the possibility of missing out on a huge profit if the underlying asset appreciates strongly above your strike price. 

Protective Puts

Sometimes called a “married put,” this strategy involves buying puts on a long stock position to create a price floor. You’re really buying protection against a huge drop in stock price. While this caps your potential loss, the cost of puts reduces your total return if prices don’t move or move upward.

Bull and Bear Spreads

Spread strategies involve buying and selling options at varying strike prices or expiration dates at the same time:

• Bull Call Spread: Buy a lower strike call, sell a higher strike call
• Bull Put Spread: Sell a higher strike put, buy a lower strike put
• Bear Call Spread: Sell a lower strike call, buy a higher strike call
• Bear Put Spread: Buy a higher strike put, sell a lower strike put

These strategies allow you to cap the expense of going directional while creating maximum potential for profit and loss.

Straddles and Strangles

These strategies capitalize on expected volatility rather than directional movement:

• Long Straddle: Purchase both a put and call at one strike price
• Long Strangle: Purchase both a put and call at two different strike prices (put strike below call strike)

Both strategies take advantage of high price movement in either direction but require enough movement to cover the cost of both premiums.

Risk Management with Options

While options can create leverage and magnify returns, good risk management is still necessary to long-term success.

Position Sizing

Never risk more than a small percentage of your portfolio on speculative options positions. Consider:

• Limiting speculative options trades to 1-5% of your portfolio
• Enabling you to comfortably lose the entire premium without jeopardizing your financial state
• Position size increases only after having established steady profitability

Hedging Strategies

Options are better hedging tools to cover other investments. You can:

• Use puts to hedge long stock positions in uncertain situations
• Investigate collars (purchase of put options and sale of call options) to establish price ranges
• Use calendar spreads to manage earnings announcements or other events

Managing Assignment Risk

When trading options, you must understand the risk and the implications of risk assignment. Some ways to do this include:

• American-style options may be exercised at any point before expiration
• Dividend dates may cause early assignments
• Have sufficient cash or shares in reserve to meet potential obligations

Common Misconceptions and Pitfalls with Options

New options traders become victims of common misconceptions that can prove expensive.

“Options Are Just Like Gambling”

This misunderstanding is due to speculators who buy out-of-the-money options expecting huge gains without realizing the probability or pricing. In the real world, options are powerful tools that can be applied conservatively or aggressively based on your plan and risk appetite.

What most folks aren’t aware of is that option sellers usually have the odds in their favor, and the statistics show that some 60-80% of options expire worthless. That is not necessarily an argument for selling over buying—it only underscores the importance of understanding probability and time decay.

Neglecting Implied Volatility

Knowing implied volatility (IV) is most critical when option trading. Purchasing options when IV historically is at an all-time high typically has disappointing results even if your call of direction is correct. The premium you are paying may be so artificially inflated that the position still creates a loss despite good price movement.

Think of it this way, options trading without concern for volatility is like sailing a boat without weather reports in mind.

Overtrading

The power of options leverage is sufficient to tempt numerous traders into over-leveraging themselves. Over-trading capital or holding too many positions is a guaranteed recipe for losing plenty of money in a hurry.

Remember that patience and selectivity are virtues while trading options. One of the best option traders in the world makes comparatively few trades but each one is irresistible on a risk-reward basis.

How to Get Started with Options Trading

If you’re interested in adding options to your investing plan, the following are steps to follow in order to start:

• Education First: Take time to read about options fundamentals from books, courses, and reputable websites prior to your first trade.
• Open the Right Account: Ensure your brokerage account is sanctioned for options trading. Brokers have different prerequisites for experience and capital based on the strategy.
• Start with Paper Trading: Educate and practice using demo trading to gain experience without losing money.
• Start with Simple Strategies: Master covered calls, cash-secured puts, or defined-risk spreads prior to attempting something complex.
• Start Small: If you transfer over to live trading, begin using minimal positions to maintain your risk under control while you gain experience.

Final Conclusion

Options trading is a valuable tool in your investment arsenal when applied in the right way. Whether you want to create income, defend your portfolio, or bet on price action with minimal risk, options offer flexibility that few other tools can.

Just as success in any complicated investment approach is based on education, practice, and discipline, the same holds for options. By studying the fundamentals outlined in this book and honing your skills with time, you’ll be well-positioned to capitalize on the potential of trading options without succumbing to common traps.